Deep Dive: Reviewing a year of Morningstar US HY Index distressed opportunities
Pitchbook
5 min read
Over the past year, the distressed subset of the Morningstar US High-Yield Index presented investors with first growing, and then later diminishing, investing opportunities.
While the high-yield bond market has roughly tracked the S&P 500’s performance since last September, the Morningstar index’s distressed subset, comprised of bonds trading at an option-adjusted spread (OAS) of 1,000 bps or more, moved more independently.
Starting point The S&P 500 bottomed on Oct. 12, 2022, and then began a bull run that ended — for now, at least — in the summer of 2023. The high-yield bond market, represented by the ICE BofA High Yield Index, bottomed roughly two weeks earlier, on Sept. 29, 2022, and then began its own rally.
The day before high-yield troughed, on Sept. 28, the Morningstar US High-Yield Index’s OAS, which is a measure of the high-yield market’s level of distress, flashed a weekly warning when it broke above 500 basis points off the curve, moving that day to 526 bps. The 500 bps level is considered by many to be a red line dividing a healthy high-yield market from one not as healthy. The measure remained elevated for the next two weeks, then dropped back under 500.
The high-yield index held $77.9 billion of distressed bonds by market value on Oct. 12, 2022, translating into a weighted average price of 60.97 cents per bond. The weighted average yield-to-worst per bond that day was 23.47%.
New highs For both the S&P 500 and the ICE/BofA High Yield Index, the bull runs that began in October 2022 peaked on Feb. 2, 2023. Both indices then shed some of those gains to reach interim lows in mid-March, propelled at least in part by the negative impact of rising yields on corporate cash flows and balance sheets — and especially to SVB Financial and Signature Bank.
During that retracement, the distressed opportunity grew significantly, ultimately, and perhaps surprisingly, exceeding its size during the October 2022 equity market lows.
The index’s distressed subset’s par-value size peaked on March 29 at $143.4 billion of distressed debt and a 10.35% distress ratio. The distressed subset’s market value peaked one week later, on April 5, at $87.9 billion. That translated into a weighted average dollar price per bond of 62.15 and a weighted average yield to worst of 23.39%.
The number of distressed bonds in the index peaked at 204, also on April 5. The tally of issuers of distressed bonds reached and held its zenith for three consecutive weeks starting March 22, at 132 issuers.
Interestingly, during the February-March equity downdraft, the Morningstar US High-Yield Index’s OAS didn’t quite reach its peak attained in October 2022. It hit 517 bps on March 15, then began tightening again.
And now The S&P 500 and the high-yield market both rallied off their March bottoms, reaching new 2023 highs in the summer, before running into a typically difficult September. In that month, the S&P 500 surrendered around 5% of its value, while the ICE/BofA High Yield Index lost 3%.
But before September, as equity and debt indices rallied, the distressed subset of the Morningstar US High-Yield Index shrank. In fact, it continued to narrow even through the weak September for equities.
At Sept. 30, the par value had declined 38.5% from its peak, to $88.2 billion, lowering the distress ratio to 6.56%.
Similarly, the market value of the distressed subset had fallen about as far, dropping 39.5% to $53.2 billion. The new levels represent a weighted average price of 60.37 cents per bond, while the weighted average yield-to-worst slipped slightly to 23.27%.
Also in line, the number of distressed bonds and the count of their issuers both fell by around 40% from March through September. The issuer count hit a low of 77 on Sept. 6 and the bond count bottomed at 122 on Sept. 20, although both data points ticked higher as the quarter drew to a close.
And next Debt and equity markets are now contending with a remarkable rise in US Treasury 10-year yields, which reached a recent closing high of 4.80%, up from 4.11% at the end of August. That Treasury move should drive high-yield market prices lower and may raise the size of the Morningstar US High-Yield Index’s distressed subset.
But exactly what happens next to the distressed subset will partly depend on macroeconomic conditions, on the possible impact of the recent turmoil in the Middle East, on investor appetite for higher yields, and on issuers’ ability to handle higher financing costs. All things being equal, if investors in high-yield paper believe issuers can absorb the higher interest rate environment, OAS spreads may remain under 500 bps and the distressed subset might, for now, not grow much in size.
On the other hand, if investors perceive that these higher Treasury yields, coupled with high short-term rates, are choking off issuer cash flows, then the distressed subset might return to the peaks seen in the spring of 2023 and the OAS may again hurdle the 500 bps threshold.
